The Struggle For The Legal Tender

If You Run Short Of Money, Honey, I'll Run Short Of Time...
In our modern world of 24/7 streaming information blaring at us from the boob
tube, the financial press and the nineteen inch flat panel screen, it's pretty
darn easy to get caught up in the short term guessing game. Guessing where
financial asset prices will be in the next ten seconds, ten minutes, ten
days and ten months. Sentiment indicator after sentiment indicator has been
developed in an effort to aid mere mortal humans in guessing what the other
guessers will do next with their hard earned investment dollars. The VIX,
VXN, put/call, short interest, TRIN, bullish/bearish surveys, over bought
and over sold oscillators, you know the rest. We don't mean to make light
of shorter term, chart driven sentiment indicators. They can be quite useful
in helping to gauge entry and exit points while actively managing assets.
But, what may be the ultimate sentiment indicator of the moment is cash flow.
Clearly a study of corporate cash flow would have tipped one off to many
a corporation stretching the interpretation of GAAP for many moons now. A
clue that creative accounting was a deadly serious issue long before it "showed
up on TV" or the front page of the Journal. What about cash flow as
it pertains to the broader investment community? What may be incredibly important
is how this question is currently being answered by Main Street America.
Not answered in any type of survey, but rather with the pocketbook.

As you know, the bull market of the 1990's was a bull market characterized
by full participation from Main Street America. Mom and pop investors far and
wide provided the monetary fuel so necessary for financial asset prices to
move ever higher. An era of public participation not witnessed since the period
of the late 1960's and early 1970's. As it turns out, the year 2001 was notable
not only for the continuation of an equity bear market as severe as anything
seen in three decades and a wake up call in terms of global security, but also
for the fact that the Main Street American love affair with equities displayed
clear signs of coming to an end for now. Like a western gold rush town turned
ghost town years after the last nuggets were pulled from nearby mines, Main
Street was relatively deserted in 2001 in terms of US equity mutual fund inflows.
Only the wind and tumbleweeds dancing along the cobblestone streets. The worst
showing in a decade:

The official ICI (Investment Company Institute) number for 2001 revealed that
total equity fund net inflows for the year registered a paltry $39 billion.
Relative to record year 2000 inflows, the 2001 experience was a hair over 10
cents on the dollar. This $39 billion figure includes inflows to US based equity
funds that invest in foreign equities. For US specific funds (which is shown
in the chart above), the inflow number was approximately $55 billion, down
80% from year 2000experience. (Clearly there was outflow in foreign oriented
funds.) As witnessed by this pocketbook participation, America's love affair
with equity mutual funds may have come to a rather silentend last year. At
best, maybe this is temporary. At worst, and if history is any guide, it may
be over for a good while. So far, unspoken by the streaming media cognoscenti
of the CNBC's of the world. Not given too much press in Street strategist missives
on the future. Net yet found on the front page of financial media must-reads.

Characterizing what may be additional signs of growing public respect for
risk, inflows to bond funds lit up like a skyrocket in 2001. Likewise, moneys
that did flow into US specific equity funds found the largest portion being
allocated to Growth and Income, an asset class that had gone begging into the
height of the bull market. The following chart details the change of heart
on the part of American investors during 2001 in terms of where their hard
earned dollars were being invested in the greater equity fund complex, or not
being invested for that matter:

The Law Of Diminishing Returns?...
Incremental change can often be an incredibly powerful force. Change at the
margin is often the first sign of the beginnings of broader shifts that ultimately
are fully recognizable only in hindsight. In financial markets. In the real
economy. In human perception change. A stock that simply stops reacting positively
to continued good news. Or, conversely, a stock that won't sell off any more
on a continual stream of disappointment.

Even though absolute dollar levels of public participation in equity mutual
funds increased at relatively significant amounts as the 1990's bull market
wore on, the law of diminishing returns was already beginning to set in well
before the final dollar peak in fund inflows during 2000. To the point where
the record year 2000 inflows paled in comparison to the then existing asset
base of the equity mutual fund complex in its entirety. Now that absolute dollar
flows have diminished substantially from that record peak, current contributions
are simply becoming rounding errors relative to existing assets: :

Important from the standpoint of affect on price. If 2001 is the beginning
of a trend of lower absolute dollar inflows to equity funds ahead, it can pretty
well be surmised that the bulk of public fuel (cash into these funds) has already
been spent. Fuel that drove the bull market occurrence in the first place.

First There Is A Mountain, Then There Is No Mountain, Then There Is...
In further exploring the meaning of public allocation of cash, another perspective
on the potentially ending honeymoon with equities may be seen in the money
market fund complex. As you know, we simply cannot count the number of times
we have witnessed Street seers refer to the "mountain" of money
just waiting to dive into this market. We keep scratching our heads given
the fact that there just has not been that much selling to create this mountain
of anticipatory cash. Plenty of credit creation to stoke money funds, though.
From the folks at ICI, here's a little view of life seldom seen in most explanatory
Street presentations regarding the oodles of cash "circling the game".
Just waiting to pounce:

If this money is ultimately destined to purchase the mom and pop new era equity
vehicle of choice, then there is no mountain (relative to what has already "pounced",
so to speak). As you know, this chart is a study in human trust. In belief.
Implicitly, also a study in price.

All That I Am Askin' For Is Ten Gold Dollars. And I Could Pay You Back
With One Good Hand...
In complete coincidence with the significant decline in equity mutual fund
inflows over the last year is the fact that existing cash in domestic equity
mutual funds is also quite low. In fact very low from a historical standpoint.
During December of 2001, cash in equity mutual funds declined by about $8.5
billion. Meaning that equity fund managers spent all of the inflows for the
month and then some. No great mystery as to why. After one hell of a 4Q in
terms of index performance, showing significant cash in the old portfolio at
year end (implicitly telling the world one did not fully participate in the
4Q rally) would have been a distasteful "career move" for most equity
fund managers. Of course this cash, which represented approximately 15% of
total year 2001 inflows into US specific equity mutual funds, was put to work after the
market had already risen and just prior to a sloppy January.

Year end 2001 cash in equity mutual funds dropped to 4.9% of total equity
fund assets. It's the lowest reading seen since August of 2000. You remember,
the month just prior to the market really accelerating downward. Who knows
where the indices go from here, but is 4.9% cash in equity funds the level
from which new bull markets commence? Especially when equity fund inflows are
showing significant recent slowing tendencies? You be the judge:

The last time we checked, financial asset prices do not magically levitate
on their own (although sometimes it may seem that way). They need a cash buyer
to bid up their price. A sarcastic comment, but the fact that equity funds
have one of the lowest cash allocations on record, coupled with the recent
reality that mom and pop Main Street investors have significantly slowed their
purchases of equity mutual funds, just may be the ultimate, and most simplistic,
of sentiment indicators. When you are looking at the short term VIX, VXN, put/call,
etc, you are looking at the trees in a diminishing forest of cash. In the struggle
for the legal tender, equity funds are losing out in a big way relative to
at any time during the "new era".

Liquid Dreams...
While Main Street America is cutting way back in terms of parting with its
ever more precious cash, the Fed has absolutely no compunction whatsoever
about allowing the creation of more and more of the stuff. As we head into
2002, it's our feeling that we are moving into global economic and financial
market waters uncharted at any time over post war history. If indeed we are
headed into an inventory rebuild cycle near term, as we believe, that will
stabilize and at least temporarily uplift macro economic readings, this stands
to be one of the most academically mild (by the numbers) recessions in many
a decade.

In stark contrast stands the fact that we are in the midst of one of the greatest
multi-year downturns in corporate earnings on record. These two seemingly incongruous
characterizations of the current environment leave us to believe that the current
experience is far from typical or historically "average" in nature.
The purging of classic excesses simply has not happened. Housing, auto sales,
debt accumulation - none of these has turned down even for a second during
this so called recession. What may certainly be different about the current
experience is the incredible desire of the Central Bank to placate the moment.
To attempt to put off what has been natural economic reconciliatory pressures
of recessions past. The action of placating the moment this go around is either
a stroke of genius, if we can avoid widespread economic pain, or a misguided
plan that allows excesses to continue accumulating in fallacious fashion. Forestalling
ultimate and most likely even more painful reversion to some type of normalcy
ahead.

The Fed's pass on a rate cut this week may signal the end of the rate cut
cycle for this economic interlude. We would not rule out another 25 or so basis
points on the downside, but at this point it's largely moot as potentially
being a significant catalyst for immediate economic change. The most significant
issue ahead in our minds is money growth. Forget interest rates. When will
the Fed have the resolve to back off on the money supply accelerator? It's
a paramount question for both the economy and the financial markets ahead.
At the moment, a bit momentous for financial asset prices as the public investor
is fading from the limelight as a sponsor of price acceleration vis-à-vis
cash flowing into the conduit of equity funds.

From the early 1960's until the early 1990's, year over year directional change
in M3 and in the economy, as measured by nominal GDP, pretty much moved in
similar fashion. Until the last decade:

Another way to view the relationship in the chart above is to look at the
difference between year over year M3 growth and year over year GDP growth as
follows:

Year over year M3 growth relative to year over year nominal GDP growth is
currently at a four decade extreme. Historical periods of near similar peak
experience have been quick spike-like affairs. Not a decade long process that
has built upon itself each step of the way as we know seem to witness. IF the
economy recovers significantly, this relationship reconciles itself. If not,
reconciliation lies only in the hands of the Central Bank. The Fed may be done
cutting rates for now, but will they truly allow system wide liquidity growth
to slow to a pace more consistent with nominal GDP growth near term? At best,
we would suggest that the current relationship seen above is unsustainable
over any longer period of time. How it ultimately reconciles remains to be
seen.

Somebody Stop Me...
The mutual fund data presented above is a wake up call in our opinion. An indication
that public sentiment regarding equities has shifted from the rabid avocation
of even just a few short years ago to something much more subdued in terms
of new purchases. Raising serious questions regarding the nature of the financial
asset supply and demand equation ahead. Possibly more meaningful on the road
right in front of us will be money supply growth allowed by the current Central
Banking cast of characters. With the even more ominous question lurking in
the background of how long foreign capital parked in US dollar denominated
assets will tolerate what seems an unending supply of "new money" in
the US financial system. It is certainly our contention that Fed liquidity
creation is providing at least some type of downside cushion to the current
financial market environment. Certainly enough to cushion and offset the
diminishing appetite of the public. Humble question: Who is going to cushion
the potential downside in financial asset prices when the Fed either decides
or is forced to temper its allowance of money growth? At the moment, that
is the tension found within the legal tender. As you would suspect, it is
more of a struggle than not in identifying an acceptable answer or eventual
outcome.

Contrary Investor is written, edited and published by a
very small group of "real world" institutional buy-side portfolio managers
and analysts with, at minimum, 20 years of individual Street experience. Our
credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance.
We are all either partners or employees of institutions with at least $1 billion
under management.

Contrary Investor is our vehicle for providing what we
believe is institutional quality financial market research, analysis and commentary
that is characterized by honesty, integrity and credibility. We live the business
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Investor. Having checked our egos at the door many moons ago, we hope to allow
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of any one individual getting in the way. No investment guru's here. Just lifelong
students of and participants in an ever-changing financial marketplace.